On Imperfect Commitment in Contracts

Abstract

In this paper I consider a repeated buyer-seller relationship wherein a seller has private information on his fixed cost parameter. Once a buyer pays for the good - but before its delivery - he may fear opportunistic behavior by the seller; the latter may prefer not to produce, in which case he pays a penalty and the trade is terminated. Depending on the magnitude of the penalty and the valuation of the future I identify three contractual regimes corresponding to the strength of legal system. The optimal stationary contract consists of two distinct parts. For the most efficient types of seller, the contract entails bunching with a fixed payment and a fixed output. For higher costs output is significantly reduced below the optimal static mechanism.